Thursday, 22 July 2010

“Wall Street, runs the sinister old gag, is a street with a river at one end and a graveyard at the other. This is striking, but incomplete. It omit’s the kindergarten in between.”

Fred Schwed (1901-1966), US Author

There were a number of causes, all mostly avoidable, which contributed both collectively and cumulatively to the debacle in the financial markets, given the sobriquet “The Credit Crunch”. By and large the ‘factors’ were as a direct result of monumental errors of judgement, and commonsense by many extravagantly remunerated people in various positions of high responsibility, who frankly should have known better.

3. The governments backstopping of Fannie and Freddie, along with the federal agenda of promoting home ownership, contributed to the bust.

4. Rampant speculation (and abuse) in mortgages was the primary cause of the bubble, which was greatly inflated by leverage in the banking system, in particular on Wall Street.

5. The system of securitizing mortgages lay at the heart of Wall Street’s unholy alliance with Main Street, and several links in the chain made this process especially risky:-

- Mortgage issuers, the parties most able to scrutinize borrowers, had no continuing stake in the outcome.

- The ultimate investors, dispersed around the globe, were too remote to be of use in evaluating the loans.

- These investors (as well as government agencies) relied on the credit agencies to serve as a watchdog and the agencies, being cozy with Wall Street, were abysmally lax.

- Abstruse securities were more difficult to value and multi-layered pyramids of debts far more susceptible to ruinous collapse.

6. When house prices began to go into decline with an accompanying increase of mortgage defaults and foreclosures, it caused those holding Collateralized Debt Obligations (CDO’S) and similar securitized products to become increasingly nervous over the value of its investments. Prices of these investments, held in the $Billions by Banks, Insurance Companies etc rapidly fell resulting in many companies having to write off huge sums of asset values which in turn depleted their capital bases.

7. For a number of years Banks had financed themselves primarily short-term, much of it on overnight through the ‘repo’ market, inter-financial institution asset backed loans. When the value of Banks assets fell or were perceived to have fallen, Banks began becoming nervous about lending to other banks and these funds were greatly curtailed causing severe liquidity within the system.

8. Financing operations with short-term money was dependent on the ability to sell assets when necessary to correct liquidity and capital depletions but this was almost impossible given the paranoia in the markets. Thus followed failures through illiquidity or insufficient capital bases of the likes of Lehman Brothers, the ‘forced’ takeovers at relatively nominal considerations of Bear Stearns, Merrill Lynch, CitiBank, and even Goldman Sachs seeking refuge on somewhat onerous terms from Warren Buffett. Many others were coerced into yielding up equity to The Government in return for additional capital and liquidity under The Troubled Asset Relief Programme (TARP). Many Mortgage Companies were wiped out and the 2 F’s had to be effectively nationalised.

The CDS market is responsible for much of the financial belly-flop. Although the financial crisis kicked-off with mortgages, it surged with the credit crunch, when banks stopped lending even to other banks. The reason they stopped lending was mostly due to the CDS market. Because of the multiplicity of counterparties (everyone is out there punting away, a few with insurable interests but most with absolutely no direct or even indirect interests) no one knew which company held which assets, and worse: no one knew, if a company did go bankrupt, who would be hurt in the CDS market from having insured it against bankruptcy.

The failure of any one major counterparty in the CDS market would bring down the entire credit default sway market and many of its players and we are talking about some of the largest financial institutions in the world. AIG, then the worlds largest insurer by far, was brought to its knees over negligent underwriting of CDS risks and to ensure that it did not bring down other major financial corporations, over $180 billion was injected into it under TARP and effectively nationalised.

Because of this interconnectedness in the CDS and other credit derivative markets, almost all financial institutions, including many insurance companies as well as other companies in the market, are considered ‘too big to fail.’

9. The credit derivative market was devoid of meaningful regulation. In fact from the Fed downwards there was a great reluctance to impose regulations on the transaction of credit derivatives which was ‘hoisted aloft’ as ‘the perfect and healthy expression of free trade’ - a throw-back to the Alan Greenspan philosophy whilst in charge of The Fed.

In the glory days of credit derivative trading, financial institutions paid out $millions and $millions to Washington Lobbyists to ensure that the gravy train was not derailed by legislation and regulation.

Allowing the Credit Derivative Express to speed unobstructed over the financial rails and headlong into the canyon of pecuniary abyss was truly woeful, irresponsible and inexcusable.

10. Finally, the overriding weakness that contributed to much of the shocking lack of duty of care and diligence shown by senior executives in the financial institutions, advising professions such as Auditors, Lawyers, and Rating Agencies, and various regulatory bodies, festered in the method of remunerating those involved. Some examples are:-

- House loan companies paying executives for the volume not quality of mortgages sold.

- Banks giving annual bonuses without regard to the longer term profitability of the business conducted by the recipients of the bonuses.

- The Rating Agencies being paid not by the end purchasers of CDO’s etc but by the issuers and thereby undermining confidence in their impartiality.

- Senior executives of financial institutions who were forced to leave their companies due to less than satisfactory performance, were routinely rewarded with multi $million pay-offs. When Stanley O’Neal, COE of Merrill Lynch was eased out after presiding over his companies financially disastrous entry into sub-prime mortgage securitisation, he left grasping a pay-off package totalling $161 million. His successor in December 2003, John Thain was given a $15 million joining bonus and in 2007 the year before he was forced out, his remuneration package was $84 million. Shortly after he left, quarterly losses of $15 billion were revealed.

In conclusion, the entire system steadfastly avoided transparency, but even if it had been transparent it was so interconnected that there would still have been individual failures. Capitalist institutions created what was thought to be a new idea in the credit derivatives market, but its collective sharing of risk goes against the whole ethos of capitalism, which is to have individual companies compete, not to have them make contractual arrangements that cause them all to fail if one of them fail. This is not capitalism; it is more like a parody of socialism.

Afterword….long ago, an out-of-town visitor to New York was admiring the elegant vessels harboured off the Financial District; “Those are the bankers’ and brokers’ yachts!” exclaimed the guide. “But where are the customers’ yachts?” questioned the naïve visitor in response……

Where are the customers’ yachts indeed? In 1940, well respected Wall Street commentator and author, Fred Schwed strove to find the answer and deduced that a lot of the trading activity was conducted under a tenebrous cloud of fibs, bluffs, nonsense and downright lies. When his findings were reprinted 15 years later, he said that “indeed, little had changed in that period” - indeed, seemingly little has changed in the following 70 years!